Tuesday, September 30, 2008

Bleeding Out the Excess Humors: Government Spending and the Financial Crisis

In the first presidential debate last Friday, the moderator's first question was addressed to John McCain: "[A]re there fundamental differences between your approach and Senator Obama's approach to what you would do as president to lead this country out of the financial crisis?" McCain's reply began as follows: "Well, the first thing we have to do is get spending under control in Washington. It's completely out of control." He soon added: "I'm going to veto every single spending bill that comes across my desk."

Different viewers surely had different moments during the debate when their jaws dropped. Sen. McCain's assertion that Pakistan was "a failed state" caused at least one knowledgeable commentator to drop a stitch. (Sorry for the mixed metaphor.) For me, though, it was that first answer about cutting government spending that left me staring in wonder. McCain's comments indicated a complete disconnect from even the most basic understanding of macroeconomics and a mindless commitment to an orthodoxy that would make matters much worse. Perhaps worse still, Sen. Obama did not -- and arguably could not -- say as much. While his comments were true as far as they went, Obama accepted McCain's premise that we need to cut spending right now.

In two recent blog posts, Michael Dorf has pointed out that, even on its own terms, McCain's proposed spending freeze would not actually cut spending and that government spending fails to explain either the origins of the housing crisis or how McCain could support the now-defeated rescue bill if he believes his own explanation. All true. The problem, though, is much more fundamental (to use one of Sen. McCain's favorite words): cutting spending right now would be the worst thing to do.

Let's put aside for now whether government spending is the culprit in getting us into this mess. (I don't think that it is, but that's irrelevant for now.) Let's also put aside whether there are long-term fiscal imbalances that need to be addressed. (I strongly suspect that those problems are overstated, but I readily acknowledge that reasonable people can disagree.) The question that McCain and Obama addressed was what to do when one of them becomes president in less than four months. They said that we should cut government spending. This is utter foolishness.

One cannot, of course, do justice to the macroeconomics of deficit spending in one short blog post. Perhaps the most direct way to put the point is this: Cutting spending when the economy is already weak and getting weaker is like bleeding a dying patient. Consumers are scared, many are losing their jobs, and access to credit to buy things is drying up. We can thus expect consumption spending to weaken considerably. Businesses have lost access to credit and, more importantly, have lost any plausible reason to invest in expanding their businesses in the face of a potentially disastrous recession or even depression; so we can similarly expect business spending to continue to weaken. The rest of the world has caught our financial contagion, and most of our trading partners have seen their economies weaken significantly in recent months. Notwithstanding the tanking of the U.S. dollar, therefore, exports will not bail us out. State and local governments are already in the process of slashing budgets as their tax receipts shrink. The only pillars remaining to bear all the weight of propping up the economy are thus federal spending and tax cuts. (Tax cuts, as welcome as they would be for strapped consumers, are also less likely to be spent by people who are understandably scared about their immediate futures and who thus need to put as much aside as they can.) Yet the candidates say that the first thing they would do is cut federal spending. Let's open another vein and see if the patient gets better!

The most generous thing one can say about this lunacy is that one or both senators is really against "wasteful spending," not all federal spending. If so, neither even came close to saying so. Still, it is counter-intuitive but true that even wasteful spending is better than no spending at all when the economy is down. The scientist who receives a grant for studying the DNA of bears in Montana, after all, buys groceries and pays rent. I would be the first to say that we should always try to spend government money on non-wasteful projects (though I see no reason why the infamous bear DNA study is thought to be presumptively wasteful); but neither candidate is talking about keeping up the same level of spending by shifting funds from dumb stuff to smart stuff.

We will need a stimulus package, and we will need it soon. Yet neither party's nominee (nor any of the other leaders in Washington) will say as much. Given that Sen. Obama leads the party that has traditionally been more open to the idea that at least temporary government stimulus is necessary, why did he at least not say something about the foolishness of cutting spending right now? Just as some people still like to blame Bill Clinton for the country's problems, I blame him for this.

The essence of Clinton's triangulation strategy was to accept his opponents' critique of "old Democrats" and claim that there is a Third Way that accepts the wisdom of both sides and rejects their excesses. Sounds nice. In the case of government spending and deficits, Clinton's strategy involved accepting the idea that government is bad and refusing to defend the important roles that government must play. While I suspect that Clinton understood that cutting spending in a situation like the one we currently face would be the height of folly, the reality is that his rhetorical stance undercut the ability of anyone in national politics to stand up for real fiscal sanity. If Sen. Obama had said: "You know what? Cutting government spending right now is the exact opposite of what we should do," everyone would have been shocked. Republicans would have had a field day, and Democrats would have distanced themselves from his comments. (A congratulatory blog post from me probably could not save his campaign.)

In short, strategic capitulation on matters of principle comes with a price. Right now, the best we can hope for is that the next president will ignore the conventional wisdom (and his own words) and realize that an economy on its deathbed needs all the life blood it can get.

18 comments:

One related point: If I recall my history correctly, spending-cuts in order to bring more 'balance' to the federal budget was precisely what Herbert Hoover advocated and did in the early 30s leading up to the 1932 election.

Intriguingly, Roosevelt at first favored govt spending cuts as well, as he'd enjoyed some success along these lines as Gov of NY. He learned quickly upon assuming the White House, however, even before publication of Keynes's General Theory, that a severe economic downturn was no time for spending-cuts.

Roosevelt seems to have been of a particularly flexible, pragmatic disposition, restlessly willing to try new things when it became clear that old medicines won't work. I've an odd feeling that, in the debate last Friday, we were watching a (less competent) Hoover on the one hand, a (somewhat more cautious) Roosevelt on the other.

Thanks, Bob. One point against FDR (to whom I otherwise give great credit, for exactly the reasons that you summarize) is that he reverted to fiscal orthodoxy in 1936 after the economy had started to recover. This led to the "double-dip" in the Great Depression, which was only fully reversed with the involuntary military Keynesianism of WWII.

Well, firstly, I certainly agree that McCain's blaming this "crisis" on government spending is nonsense. However, your assertion that government spending is the basic macro-economic fix does not ring true. There is nothing in this current "crisis" that suggests any issue with the economy writ large having a problem. There is nothing - at least nothing being discussed - that indicates that a problem exists at all, outside of cash flow in the financial markets. I don't see how generic government spending is relevant at all to this current "crisis." Thus, slowing or increasing generic government spending should have no effect on the "crisis" in the financial markets.

Until someone actually provides argument and evidence that does not start with the assumption that our economy is in a crisis, I will continue to think that the best thing the government can do is nothing.

With reasoned discussion, I could be convinced otherwise, but in any event I am certainly glad the "bailout" failed to pass. This is not an issue that - like Iraq - should be dealt with in crisis mode. Action, for actions sake, is rarely any good. We have months, if not years, to deal with this. Not the days that many are pushing. Frankly, if we are eventually going to need to act in a major way to "fix" this issue, I would rather it be done by someone appointed by Obama than - as Michael Lewis would say - a Big Swinging Dick - like Paulson.

Neil, great points, but I heard Senator Obama as being extremely uncomfortable with cutting spending right now. Didn't the commentator have to ask him multiple times what he would cut? and each time he held back on saying it would be needed? It was not, in my view, waffling of specifics but rather discomfort with the premise of the question.

With your expertise on tax law, could you address an idea I've been batting around recently? I think we will only continue to decline as long as we fail to address the growing, massive income inequality--Reisch's $64,000 question from a few years ago. I'd like to see our corporate tax rates change so that they are based on the ratio of highest to lowest compensation in the company. Presumably, CEO pay would decrease and the compensation to median workers would increase. I'd cut off corporate taxes when the ratio fell below a certain point. Didn't Ben and Jerry used to have a ratio of 20:1? Would individual income tax increases balance out losses in corporate taxes for companies below that ratio? Could income inequality start to correct?

(1) I can see your point about Obama's hesitation. Still, he talked about delaying his spending initiatives when he should have been saying that the weakening economy is an important reason to speed up his spending initiatives.

(2) I like your points about income inequality and will blog on them soon.

(3) Please email me to discuss matters that I will not include in the upcoming blog post.